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A Bullish Forecast For The Natural Gas Market Through 2012

As I stated in my previous article
The Natural Gas Oversupply and How to Play It
, although the long-term outlook for demand and pricing remains
favorable, the current supply overhang of natural gas is going to
constrain prices for natural gas in the near term. As you can see
in the graphs below, the supply side for natural gas lacks any
meaningful catalysts for a durable recovery in natural gas
prices.Weekly US natural gas storage statistics provide meaningful
insight into the "closed" North American markets. Here's a look at
US working gas in storage relative to the five-year maximum,
minimum and average storage levels.

Source:
Energy Information Administration

The amount of natural gas in storage began 2011 near the
five-year maximum--a symptom of a severe oversupply. During the
winter months, storage levels declined to meet elevated demand for
heating. By the end of this year's winter withdrawal season,
natural gas inventories were in line with the five-year
average.

Meanwhile, storage volumes have increased at a
slower-than-average pace this summer.

Normally, one would expect below-average supply to be supported
with stronger prices; however, investors must scrutinize the
factors behind the decline in gas storage levels relative to
seasonal norms. In this case, an unusually hot summer is the
culprit. Check out this graph of US cooling degree days (CDD), or
the difference between a day's average temperature and 65 degrees
Fahrenheit. For example, if the mean temperature on a given day is
90 degrees, that would equate to a CDD of 25.

Source:
National Oceanic and Atmospheric Administration

As of the most recent week's data, summer 2011 has been about
9.6 percent hotter than the five-year average. In fact, July was
one of the hottest months on record in the US. Natural gas is used
to produce electricity and run air conditioning systems, hence
above-average summer temperatures are behind the uptick in gas
demand.

Traditionally, US demand for natural gas declines rapidly from
mid-September to mid-November in advance of the winter heating
season. Meanwhile, the supply of natural gas remains robust.

Source:
Energy Information Administration

The US Energy Information Administration releases data on
marketed US natural gas production with a three-month lag. As you
can see, US gas output in May reached an all-time high of roughly
66 billion cubic feet per day, and production held steady in
June.

Producers continue to scale back their capital expenditures on
gas drilling now that acreage in unconventional dry-gas fields such
as the Haynesville Shale is held by production. Chesapeake Energy
Corp, for example, has allocated 75 percent of its 2012 budget to
liquids production--a business that offers superior margins--and
only 25 percent on natural gas. In 2011 the firm spent roughly
equal amounts on liquids-rich and dry-gas plays. The decreased
investment in natural gas drilling is also visible in the US
natural gas-directed rig count.

Source: Bloomberg

The number of rigs targeting natural gas dropped off sharply
when commodity prices collapsed in late 2008-09. Despite depressed
natural gas prices, the rig count stabilized and began to increase
into mid-2010. This apparent disconnect between natural gas prices
and drilling activity stemmed from contracts that required
operators to sink a commercially productive well within a specified
time frame to extend their lease hold. Producers also stepped up
drilling in plays that contained high-value natural gas liquids
((NGLs)) such as ethane, propane and butane.

Since mid-2010, the US gas-directed rig count has declined by
about 10 percent. But this drop hasn't restricted US natural gas
output. In fact, US gas production has accelerated. As producers
gain experience in the nation's shale gas plays, the efficiency of
their drilling operations has improved immensely. Today, operators
sink wells at a much quicker pace and have optimized their drilling
and hydraulic fracturing techniques to maximize output.

Producers have also shifted rigs from higher-cost fields to the
most prolific plays. In the hottest unconventional plays, producers
continue to benefit from the relatively high value of NGLs
contained in raw natural gas streams. (See
Why Some Natural Gas Is Worth $7.28
.)

These trends appear to have lowered the equilibrium price for
natural gas--the price at which producers are incentivized to ramp
up drilling--to the neighborhood of $5 per million BTUs from as
high as $7 per million BTUs. Some gas-producing fields are even
profitable when gas goes for less than $4 per million BTU.

Adjustments on the supply and demand side eventually will return
natural gas prices to between $5 and $6 per million BTUs. Low
prices and lower CO2 emissions will drive the shift to natural
gas-fired plants, while industrial users will also increase their
use of natural gas. Supply growth should also level out as
producers allocate more money oil-rich plays.

But natural gas prices will remain constrained in the near term.
Lately, the US gas-directed rig count has stabilized and ticked
slightly higher. As demand for natural gas moderates in the fall
shoulder season, expect the volume of natural gas in storage to
exceed the five-year average.

The prospect of hurricane-related shut-ins has also buoyed
natural gas prices in recent weeks. Tropical Storm Lee dumped a
deluge of rain across the Gulf Coast, forcing operators to
temporarily evacuate some rigs and interrupting gas processing
operations in the region. This disruption could cause a temporary
dip in US natural gas and oil inventories, causing natural gas
prices to rally. However, these gains will evaporate once hurricane
season winds down.

My current forecast calls for the 12-month strip for Henry Hub
prices to hover around $4 to $5 per million BTU, though prices
could pull back dramatically when gas storage volumes rise to
above-average levels.

If natural gas output moderates in 2012, we will consider adding
some exposure to North American producers. At this point, there's
no sign that supply overhang will subside.

Note that we remain bullish on international markets for natural
gas. Not only does LNG demand continue to increase in emerging
markets, but Germany's decision to
phase out its fleet of nuclear reactors
will also force the country to increase its reliance on natural
gas. A tightening supply-demand balance has pushed natural gas
prices in the UK to roughly $11 per million BTUs, while supply
contracts in Asia are often indexed to the price of Brent crude
oil.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

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